Repeated Lessons in Buffett’s Partnership Letters

April 17, 2020 by Jon

Buffett’s Partnership Letters hold a number of lessons for everyone. Some stand out more than others because Warren Buffett repeats them throughout the letters. Those lessons are worth repeating again.

It is always startling to see how relatively small differences in rates add up to very significant sums over a period of years.

Exponential growth doesn’t come naturally to everyone. Mostly because it’s hard to imagine the huge amount of growth that happens on the backend based on what we see on the frontend.

To help his partners understand it, Buffett wrote three versions of alternate history to explain it. He rewrote the history of Christopher Columbus, da Vinci’s Mona Lisa, and the sale of Manhattan. His stories offer a fun way to rewrite historical outcomes and show the power of compounding.

For example, suppose Ferdinand and Isabella stayed out of the venture capital game entirely. Rather than provide the seed capital for Columbus’s voyage, they instead stuck with a conservative plan and invested at a meager rate of 4% annually. Spain would have seen its small fund, compounding over five centuries, grow to $2 trillion.

Buffett followed up each story by comparing the compounding effect of different rates of return.

The lesson is simple math. Compounding even a decent return over many years can have a huge impact on your final tally.

…the Dow as an investment competitor is no pushover…

Buffett’s benchmark of choice was the Dow. It was easily the most well-known index a the time, so it made sense to tie a lot of what he did to the Dow.

He set his own performance goals to the Dow based on the long-tern return he expected to earn the partners. He also set goals based on whether the Dow was positive or negative. To him, beating the Dow meant matching it in up years, while beating it in losing years.

Which, in turn, gets to the real purpose. His writing played a big role in managing his and his partner’s expectations.

Having a yardstick offered a few obvious benefits. It gave the partners a reason not to view positive or negative returns as good or bad but good or bad relative to the yardstick.

Every year, he compared the Dow to the performance of popular mutual funds. In doing so, he showed that the Dow was tough to beat.

Since the Dow was tough to beat, and his strategy was different than the Dow, not beating it one year shouldn’t be shocking. Besides, that wasn’t the goal. And the market can get crazy over shorter periods, so falling short in any given year was a possibility.

As Buffett proclaimed annually, it was best to judge performance over several years. Three years was the minimum — five was better — time needed to judge good performance, so long as the period experienced both strong and weak markets.

He had one final, less obvious, use for it — position sizing. Buffett’s position sizing decisions were based on an investment’s expected return and how likely it would experience worse performance relative to the Dow. Given two investments with similar expected returns, the one with the lowest chance of underperforming relative to the Dow earned a higher weighting in the portfolio.

The lesson: Good benchmarks allow investors and clients to set expectations and objectively judge performance over time because they are so tough to beat.

The complexities of national and international economics make money management a full-time job. A good money manager cannot maintain a study of securities on a week-by-week or even a day-by-day basis. Securities must be studied in a minute-by-minute program. — Go-Go Fund Manager circa 1968.

The quote is a glimpse into the market mania of the late 1960s. Go-Go funds hit their peak around ’68. These were growth funds, like Gerald Tsai’s Manhattan fund, that ended the decade in a speculative frenzy.

Buffett repeated in the last several letters that he wasn’t comfortable investing in the environment. The frenzy around tech and other stocks seemed like a popularity contest.

To him, it was a “distortion of a sound idea.” The focus on long term performance shifted to the short term. Earning the highest return possible in the shortest amount of time became the priority.

Buffett couldn’t relate to it. It was outside his comfort zone. Within two years, with the number of opportunities drying up, he announced his retirement. One final nod to his mentor explained partly why he called it quits:

I find it much easier to think about what should develop over a relatively long period of time than what is likely in any short period. As Ben Graham said: “In the long run, the market is a weighing machine – in the short run, a voting machine.” I have always found it easier to evaluate weights dictated by fundamentals than votes dictated by psychology.

The lesson was something Buffett preached from the start. He refused to change his strategy and play a game he didn’t understand. He’d rather pass on what appeared to be big easy gains because it meant accepting a much higher risk of permanent losses.